Optimism brews, but the bad news bubbles away

Economists use a variety of complex indicators to gauge the health of the economy, business sentiment and consumer confidence. Ben Bernanke, the US Federal Reserve chairman, is said to favour something called the "personal consumption expenditures price index". Less scientific, but illuminating in its own way, is the more obscure "passive survey of mass-market caffeinated-beverage franchise patrons". The methodology behind this little-known indicator is complicated, but it boils down to sitting in a Starbucks and eavesdropping on fellow customers.

This barometer is especially useful in the US, because Americans are particularly talkative and so tend to discuss in public, with little hesitation, the most intimate details of their personal and professional lives. This time a year ago, one could sit in a Starbucks in New York and overhear seemingly ordinary people describe their negotiations for higher pay, plans to expand their business abroad or how they were going to outsource their back-office operations to India.

Those people are gone. In their place are others with decidedly less promising issues to share with those within earshot. Some are on their mobile phones canvassing for jobs to replace the ones they've lost. Some are scribbling out household budgets to reflect diminished prospects. Some are just asleep, taking advantage of the privacy afforded by their hooded tops and rousing only to discuss finance and housing issues with friends.

But there is oddly no air of despondency among the Starbucks denizens. Perhaps even more remarkable is that they are there at all. That may be testimony to the addictive power of the demon bean, or it could illustrate the latest message from economists in the US, that despite the continuing gloom in the global economy there is cause for hope and, dare it be said, optimism. That isn't to say things are getting better. On the contrary: this week the World Bank issued a darkened forecast for the global economy, predicting a 1.7 per cent contraction this year, compared with an earlier prediction for 0.9 per cent growth.

Hooray! A worsening global economic recession, probably the worst since the Great Depression! Naturally, financial markets are rallying, with New York's benchmark Dow Jones Industrial Average posting its best month since 2002. Have investors gone insane? Is Starbucks slipping Librium into its Pike Place Blend? How does anyone look at the latest numbers and think things are looking up? To answer, economists use the analogy of a roller-coaster ride. When a roller coaster stops its first vertical, zero-gravity plunge, passengers start to regain faith that the car is going to level out. The spills aren't over, but the prospect of losing one's lunch seems less likely.

So it is with the economy. "We're still in the midst of the recession but the pace of descent may already be slowing," says Hung Tran, the director of the emerging markets policy department at the Institute for International Finance in Washington. US home prices are still falling, but last month homes sales unexpectedly jumped as falling mortgage rates lured new buyers. US consumer sentiment is dawdling near its nadir, but last month it twitched upwards.

Investors are betting that a decelerating decline implies the economic cycle is tracing a curve that is flattening and that, in due time, will reverse course. Hence, lending rates between banks are starting to fall and corporate bond yields are easing as investors conclude that while economic conditions are awful, they are unlikely to get much worse. "The nature of this global recession is that it is a prolonged one and we're not out of the woods yet," says Tony Meer, the chief economist at Deutsche Bank in Sydney. "But at least what we've done in terms of policy and the passage of time has started to create the environment in which we're going to see some differentiation."

One indicator of this sentiment is the market for credit default swaps on US government debt. US debt is universally regarded as risk-free; there is no surer bet. Yet US credit default swaps soared in the past six months, peaking in February in what Brad Setser, an economist at the Council on Foreign Relations in New York, calls an "end-of-the-world bet". Indeed, buying insurance on the world's surest bet is like buying insurance against Armageddon. Who would be around to pay or, for that matter, collect?

Thus, analysts take it as a return to sanity that US credit default swaps have almost halved in the past two months. The world, investors are concluding, is not ending. Optimism seems almost too strong a word. Call it a retreat from despair. Whatever it is, it seems to have achieved critical mass in the past week, after the US Treasury secretary, Timothy Geithner, revealed plans for buying up the toxic assets eating away at banks' balance sheets and preventing them from resuming their role as economic heart muscle.

Ridding the system of these toxins will require amputating some institutions, but it means the system will not succumb to gangrene. Some, like the head of the People's Bank of China, have voiced concerns that the cost of this effort, combined with enormous borrowing to pay for fiscal stimulus, jeopardises the very value of the US dollar. The US has begun essentially printing dollars, reducing the relative cost of repaying its biggest creditors, including the UAE, Saudi Arabia, Japan, South Korea and China.

But Mr Tran says these countries should be less concerned about the value of their interest payments than about whether the US manages to resuscitate its demand for their exports of oil and manufactured goods. The Gulf and Asia may therefore be in for tougher times before seeing the kind of improvement investors anticipate in the US. For the next three to six months, Mr Tran says, those of us in emerging markets will just have to "grin and bear it". [e-mail]